Stocks - December 2008

This One Might Hurt A Bit As readers of this column might recall, over the last year or so I’ve written extensively on the topic of “peak oil.” Peak oil of course is the theory that the productive capacity of the world’s oil fields reached the practical limit. As recently as last year, while worldwide oil demand was approximately 87 million barrels per day, worldwide production was unable to climb much above 85 million barrels of oil per day. So as a result of that imbalance, we saw the oil markets explode upward in price to a peak of $147 per barrel.

But things have changed in recent months — not the least of which has been the collapse in the price of oil to under $60 per barrel. Gasoline is once again in the $2.50 range. Given that price decline, does that mean that the peak oil theory is baloney? I don’t think so. Worldwide oil production is still maxing out at roughly 85 million barrels of oil per day. The reason that oil prices have collapsed is not because of a discovery of new supply. The reason behind the price collapse is demand destruction. And that is not a good thing.

Let’s translate “demand destruction” into plain English. We’re in a recession. A nasty one. And it’s spreading globally. And just to make the story a bit more interesting, consider that it just might be deeper and last longer than many are currently expecting with an eventual recovery that may be tepid, at best.

Recall from my November 2008 column (“Our Own Bad Selves”) the chart showing the huge amount of debt that we Americans have piled on, particularly in recent years. As I pointed out, that borrowing is a large part of what kept the economy growing in the late 1990s and into 2007.  In fact, it is the closing of that credit spigot that has, in large part, exacerbated the current economic downturn. Consider another set of data. Look carefully at the bar chart (courtesy of John Mauldin), which shows our country’s economic growth (GDP) over the last few years (blue). It also shows what our economic growth would have been absent the simulative effect of home equity cash withdrawals through mortgage refinancing (red).

Since 2000, GDP growth, as reported, has averaged nearly 3 percent. That’s terrific — not too hot, not too cold. That level of economic growth allows for corporate sales and profits to increase nicely (not to mention appreciating stock prices, too).

Now consider how our economy would have grown without the impetus of the mortgage equity withdrawals (that is, pulling cash out of your home to spend by monetizing your “equity” either through refinancing or adding a second mortgage). Rather that enjoying a 3 percent average GDP since 2000, GDP growth would have been only 0.5 percent. The difference is huge. Such an anemic rate of growth would affect everything in our economy. And not in a good way. Clearly, the ability to have used your home as a personal ATM and the spending of that cash gave a serious upward bump to our economy.

But that was then. This is now. The real estate and mortgage party is over. And it’s not likely to come back anytime soon.

Because of that, I suspect that the latter economic growth figure — 0.5 percent per year — more closely approximates our growth and recovery potential on the other side of this current financial mess, rather than the 3 percent or so we’ve more recently been accustomed too. In fact, until the entire debt structure that brought us here to the brink is cleaned up, it is highly likely that we will see, and will remain in, an anemic economy. I say this not to paint a gloomy picture but to consider circumstances as objectively as possible.

But even after considering that potential future scenario, take heart. Though it will take time, eventually the debt and credit mess will be cleaned up. We will get back to a more normal economic growth trajectory at some point once again.

So, getting back to oil, what does all of that mean? This, I think: So long as the economy is in the tank — as it is now — oil prices will likely remain soft. But remember this. Prices are down not because we’ve discovered new supply. We haven’t. Prices are down because demand is off.

When this economy eventually troughs and turns, growth will resume. And when that happens, global demand for oil will once again rise. When that does ultimately happen, don’t be surprised to see oil prices once again climb. Possibly to heights that will amaze.

Bo Billeaud has been president and chief investment officer of a Lafayette-based money management firm for the past 18 years. Contact him at [email protected].